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September 19, 2008

Massive Federal Bailout on the Way

New entity would buy up distressed mortgages at a discount

In a bid to stem the mammoth financial crisis the United States is now facing, top members of the Treasury Department and Federal Reserve are hammering out with Congress a plan to create a government agency that would buy distressed mortgages from banks and other financial institutions at discount prices.

Treasury Secretary Henry Paulson told members of the press September 19 that "the federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy." He continued: "This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible. The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even as it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative--a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion."

Congressional leaders have agreed to pass legislation "as soon as possible" that would establish such a government entity and "establish new FDIC-type insurance for money market funds," according to Ian Shepherdson, chief U.S. economist at High Frequency Economics. Paulson said September 19 that he would be "working with Congress to pass this legislation over the next week."

The new entity would be akin to the Resolution Trust Corporation (RTC) that was set up to close failing savings and loans and took over their assets. The new entity "will aim only to remove bad assets from banks' books in order that the healthy parts can continue to operate," Shepherdson says. "Banks will likely have to crystallize large losses because [the new entity] will take the assets at a discount (it should, in time, make a profit, whereas RTC lost $125 billion) but the gain is that they avoid the fate of Lehman," referring to the troubled investment bank Lehman Brothers that was forced to file for Chapter 11 bankruptcy protection on Sep. 16. Shepherdson added that this plan "is a gigantic step forward, the only way to fix the crisis. The economy is still a mess, but systemic risk is way down."

Treasury has also said that it would guarantee money market funds for the next year by tapping into a Depression-era fund. The backing comes from the department's Exchange Stabilization Fund, which was created in 1934 to backstop the dollar. "For the next year, the U.S. Treasury will insure the holdings of any publicly offered eligible money market mutual fund--both retail and institutional--that pays a fee to participate in the program," Treasury said in a September 19 release.

Meanwhile the SEC has temporarily prohibited short selling in financial companies. "The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets," said SEC Chairman Christopher Cox in a statement "This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and the Congress."

The SEC said in the statement that the banning of short selling "calls a timeout to aggressive short selling in financial institution stocks, because of the essential link between their stock price and confidence in the institution. The Commission will continue to consider measures to address short selling concerns in other publicly traded companies."

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